Transaction cost, holding period and return volatility: an investigation of the stock market microstructure on the Chinese stock market

The newly established Chinese stock market presents us with an interesting case-study of a market which has distinct features and special microstructures. This thesis focuses on the investigation of transaction cost, stock holding period and return volatility with a market microstructure approach. The chapters are mainly motivated by the following issues.
1. What causes the transaction costs disparity of Chinese domestic and foreign-shares? Chapter 3 explores the characteristics of Chinese domestic and foreign shares and examines the transaction cost (measured by bid-ask spread) of the individual shares. We find that the average transaction cost of foreign shares is significantly higher than that of domestic shares. We estimate informed-trading cost component of transaction cost for each share and find it is higher for foreign shares than for domestic shares. After controlling for the informed-trading cost, the transaction cost disparity disappears. Our finding suggests that the higher transaction cost of foreign shares can be attributed to the higher informed-trading costs faced by foreign share investors.
2. How do transaction cost and stock return affect investor’s holding period for a stock? Do investors in Chinese stock market tend to sell the winning stocks too soon and hold the losers too long? Chapter 4 investigates the relationship between stock transaction cost and holding period. We compute the holding period for each individual domestic and foreign shares following the method of Atkins and Dyl (1990), the transaction cost and holding period relationship is estimated by the two-stage least square using panel data. Our results provide strong evidence that assets with higher transaction costs will be held by investors with longer holding periods. We also observe that foreign share investors are more sensitive to transaction costs. The disposition effect investigation suggests a negative relationship between stock return and holding period, which indicates both domestic and foreign share investors have the tendency of selling winning stocks too soon and holding losing stocks too long. The disposition effect is stronger in the domestic share market.
3. If transaction cost and trading volume can be regarded as a proxy of information arrival, do they help on explaining stock return volatility persistence? Chapter 5 applies the popular GARCH model to investigate the dynamic relationship of return volatility, trading volume and transaction cost. Based on the mixture of distributions hypothesis (MDH), we include trading volume and transaction cost as mixing variables of information arrival in GARCH model for individual stocks. Our results confirm the relevancy and validity of the MDH for individual stocks. We also find that the trading volume and transaction cost help to explain the GARCH effects on stock return and the persistence of the conditional variance reduces for most stocks. However, as information variables, their power on explaining volatility is limited. The return volatility is better explained by previous volatility. The final chapter summarises the main results of this thesis as well as the future research plan.